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The Curious Case of the Disappearing Size Premium

The size effect was first documented by Rolf Banz in his 1981 paper “The Relationship Between Return and Market Value of Common Stocks,” which was published in the Journal of Financial Economics. After the 1992 publication of Eugene Fama and Kenneth French’s paper “The Cross-Section of Expected Stock Returns,” the size effect was incorporated into what became finance’s new workhorse asset-pricing model, the Fama-French three-factor model (adding value and size to the CAPM’s market beta). Then something unexpected happened—the size premium vanished in the United States, seemingly the moment everyone started paying attention to it.

Quality: The Missing Piece of the Puzzle

For years, the disappearing size premium puzzled researchers. The breakthrough came when Cliff Asness and his co-authors published “Size Matters, If You Control Your Junk” in 2015. They discovered the culprit: quality, or rather, the lack of it.

Here’s what they found: The smallest stocks include a disproportionate number of “junk” companies—distressed, illiquid securities with poor fundamentals. These low-quality stocks drag down the entire small-cap category’s performance. As the researchers noted:

“Small quality stocks outperform large quality stocks and small junk stocks outperform large junk stocks, but the standard size effect suffers from a size-quality composition effect.”

In other words, when you screen out the junk, the size premium roars back to life.

This discovery was confirmed in 2018 by Ron Alquist, Ronen Israel, and Tobias Moskowitz in their aptly titled paper “Fact, Fiction, and the Size Effect.” Controlling for quality didn’t just restore the size premium—it:

• Revived the size effect after the 1980s.
• Created a cleaner, more linear relationship between size and returns.
• Spread the benefit beyond tiny microcaps.
• Reduced the concentration of returns in January (the “January effect”).
• Revealed a stronger size effect across two dozen international markets.

The takeaway? The size premium never really disappeared—it was just hiding beneath layers of low-quality stocks.

Size as an Amplifier: Where Factors Truly Shine

Beyond its role as a standalone factor, size plays a more fascinating and powerful role: it amplifies other factor premiums. Think of size as a volume knob for factor investing.

Lionel Smoler Schatz from Verdad demonstrated this by analyzing factor performance across market cap deciles. He examined roughly 10,000 global stocks, dividing them into ten groups from microcaps (the smallest) to mega caps (the largest). Within each group, he tested three factors: value, profitability, and earnings volatility.

As the table below shows, the results are striking.

Factor Performance by Company Size

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.

The pattern is unmistakable: factor premiums are loudest among small stocks and fade to whispers among giants.

What’s particularly intriguing is the earnings volatility factor, which actually reverses its sign across the size spectrum. Small companies with volatile earnings tend to underperform, while larger companies with volatile earnings have shown positive excess returns. This suggests that volatility is tolerated—even rewarded—when companies have the scale and resources to weather uncertainty.

Schatz observed the same “watering down” effect when analyzing risk-adjusted returns (Sharpe ratios), confirming that size doesn’t just amplify raw returns but also improves the efficiency of factor strategies.

The Monetary Policy Connection

There’s one more twist to the size story. Marc Simpson and Axel Grossmann, authors of the 2022 study “The Resurrected Size Effect Still Sleeps in the (Monetary) Winter,” revealed a critical timing element: the size premium appears and disappears with monetary policy cycles.

Analyzing data from 1937 to 2021, they discovered:

During monetary easing (when the Fed is cutting rates):

• The size premium delivered a statistically significant 0.41% per month.
• This held true whether or not they controlled for quality.
• The effect persisted outside of business cycle troughs.

During monetary tightening (when the Fed is raising rates):

• The size premium disappeared entirely.
• Even high-quality small stocks struggled to outperform.

This makes intuitive sense. When the Fed tightens monetary policy, economic risks increase. Small companies, with their limited resources and higher sensitivity to financing conditions, bear the brunt of these risks. Investors demand compensation for this additional risk during easier times, but flee to safety when conditions tighten.

A Word of Caution on Timing

Before you rush to time your small-cap exposure based on Fed policy, consider this: markets are forward-looking. By the time the Fed announces a policy change, markets have often already priced it in. Moreover, academic research has shown that once trading strategies are published, institutional investors (especially hedge funds) quickly exploit them, causing premiums to shrink.

With Simpson and Grossmann’s findings now public, the opportunity to profit from this pattern may have already diminished—a phenomenon known as the “post-publication decay” of anomalies.

The Bottom Line

The research points to a powerful conclusion: size is less a standalone source of returns than an amplifier that determines how loudly factors speak.

For investors, this means:

1. Don’t abandon small caps because of the “disappearing” size premium—it never really vanished when you control for quality.
2. Consider size strategically as a way to amplify other factor exposures like value and profitability.
3. Screen for quality when investing in small caps to avoid the junk that has historically dragged down performance.
4. Be mindful of the macro environment, particularly monetary policy, though attempting to time these cycles is challenging.
5. Think beyond microcaps when implementing factor strategies—the amplification effect extends across the small and mid-cap spectrum.

The size effect is alive and well, but it’s more nuanced than we once thought. Rather than viewing it as a simple “small beats large” phenomenon, we should understand size as a critical dimension that shapes how effectively other investment factors perform. In the world of factor investing, size determines not just whether factors work, but how powerfully they work.

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